EU bonds: unique complexities
EU government bonds now offer a considerably lower income than US or UK sovereign bonds. The European Central Bank has cut interest rates again and started from a lower base this cycle, leaving them less rewarding for a portfolio investor. The German ten year bond offers 2.7% a year, the French 3.3% and the Italian 3.6% compared to 4.3% on the US and 4.6% on the UK equivalent. There are no immediate threats to the EU bonds, though several countries, led by France, are struggling to control their state deficits. The ECB watches but does not fully control the differences in rates between different member states. During a period of relative calm it is wise to remember that Euro area government bonds do not have the same characteristics as sovereign bonds issued by the US, UK, or other advanced economies.
Markets usually give a higher rating to sovereign bonds compared to bonds issued by large companies or other institutions because they regard the risk of not being repaid as considerably less. Even the very large and successful companies that borrow through the bond market can face a sudden disaster, a big change of consumer demand, or major change of government policies that can hit their ability to generate turnover and profit, making it more difficult for them to pay the interest on their debts.
Sovereign governments have two powers that make paying the interest easier even in difficult times. The government can impose increased taxes on individuals and companies where non payment is a criminal offence. Taxpayers have to pay, company customers do not. The state owns and controls a Central Bank which can create money to pay bills. Whilst if done to excess this can cause inflation, it means there is no reason why a state should run out of money. It is very unlikely the democracies of the US and UK would consider not paying their interest bills.
Poorer Countries that go bankrupt do so because they need access to foreign currency and to borrowings from outside the country, giving foreign exchange markets some leverage over their conduct of policy. Printing too much will lead to a devaluation of the currency. Most sovereign bonds promise to repay in domestic currency without offering a guarantee against inflation eroding its value. This means that most governments, most of the time, get away with some inflationary erosion of their debts, whilst continuing to meet all their repayment obligations.
This should lead to some doubt over whether to regard Euro area government bonds as full sovereign bonds. Their national central banks have given up the power to create money to pay the bills: the European central Bank is now in control. As we saw in the Euro crisis, the ECB reserves the right not to make money available to member states. States do still have considerable powers to impose new taxes, but within varied EU controls. Some taxes, especially on trade and the environment, are EU taxes, as are VAT and tariffs.
In the Euro crises of 2010-13 these various controls on states created extreme financial turbulence in the banking systems, and bond markets, of countries that failed to keep sufficiently close to EU and Euro rules. In the case of Cyprus depositors placing Euros in Cypriot banks faced a major levy or tax on their deposits in what was called a 'bail in'. The European central Bank did not stand behind the commercial banks in the normal way when it saw the extent of their debts. In the case of Greece, depositors found their money frozen in bank accounts, with their withdrawals for a time limited to just Euro 60 a day. Both countries had to restructure their banks, and there were big falls in government bonds during the crisis.
In a sovereign system like the UK there are often big regional imbalances. Some regions run persistent deficits, financed by large transfers from the central government, and supported by the ready supply of liquidity to banks in the area from the national commercial banks, and if necessary from the BoE. The central institutions do not demand a correction of the imbalances. In the Euro system, the creditor countries led by Germany are reluctant to offer such a full guarantee to the deficit countries or regions. The EU imposes rules over fiscal deficits and bank capital to seek to protect them from large bills coming from the more heavily borrowed states. These rules can sometimes be tested by the markets, as they were with bad effects for bond holders and depositors in 2013.
It is true that post the Euro crises there has been more mutual support offered through the Target 2 system of clearing funds between Euro member states via the European Central Bank. It began as a short term scheme to match deficits with surpluses which were expected to be relatively small and short lived. It is still described as a settlement system, not as a transfer from surplus to deficit countries. It has become a scheme between Euro members that some say has effectively provided a set of interest free loans from the surplus countries to the deficit countries. The surplus countries make deposits at zero interest with the ECB and the deficit countries draw money out. Germany currently has Euro 1051 bn deposited whilst Spain has borrowed Euro 423 bn, France Euro 194 bn and Italy Euro 394 bn. Most agree that were a deficit country to withdraw from the system, they should have to repay the negative balance.
A new complication now arises with the decision of the EU itself to become a major borrower with its own large deficits. The EU will need to monitor total government debt, a mixture of national and EU loans. Heavily indebted countries like Italy and France are likely to be jointly and severally liable for the EU debts as well. Italy has been one of the beneficiaries of the EU loans, easing a bit of the pressure on her national accounts as she has received substantial EU payments. The addition of the EU level makes European bonds, deposits and the currency more complex than in a unitary sovereign state.
About the author
The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board.
John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.
In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios.
He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.